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Towards preparing the ground Munich Re contributions to basic discourse in takaful and retakaful, 2011–2012

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Page 1: Towards preparing the ground - Munich Re · PDF file6 Munich Re Towards preparing the ground A Risk ... Tangible calculation is preferable where possible from a shari’a point of

Towards preparing the ground

Munich Re contributions to basic discourse in takaful and retakaful, 2011–2012

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1Munich Re Towards preparing the ground

Introduction

The company boom in all three main regions of the Islamic world within the second half of the past decade brought with it a wealth of experiences – not all of them positive – regarding conceptual questions underlying shari’a-compliant insurance. It also initiated a number of important discussions, for example on the role and legitimacy of windows operations, retrocession capacity or retakaful standards, as well as the debate on the role of Saudi cooperatives and other alternative approaches. In other words, the first broad wave of practical experience sent us back to the drawing board to review some basic and long-held tenets of the industry as well as some very recent implementations. Given the number, breadth and depth of the discourses, one may well expect that resolving them would prepare the ground for a new and even stronger generation of Islamic insurance.

One tends to identify the common denominator of these questions in their relation to the understanding of the industry as being something distinct and alternative to conventional insurance and reinsurance. Is this totally true? Or are there differentiations to be made? Being distinct from conventional insur-ance is surely not a target in itself, but assuming just a few distinctive factors remain, what justification for the existence of the industry and what arguments for the buyers remain? And in the respects that remain distinct, what shape will the relationship between shari’a-compliant insurance and the conventional insurance industry take? Cooperation, distance or total seclusion? Takaful in particular has often seen itself as more, and more fundamentally, different from insurance than Islamic banking sees itself in contrast to conventional banking. Why have Islamic bankers no problems in admitting they are bank-ers, although with different rules and techniques, while takaful traditionally fails to see itself as a form of insurance, but as a replacement for it? This self-conception has to be questioned, in particular for retakaful.

This booklet is a compilation of articles published by Munich Re’s Centre of Competence for Retakaful during 2011, with some new contributions and a reworked version of the takaful typology which was part of the General Retakaful Manual published by Munich Re also in 2011. Its aim is to review a broad range of fundamental questions by shedding light on the selected main issues in not more than two to three pages per article. We hope the booklet successfully summarises the state of the discussion while at the same time focusing on the key issues and driving forward the debate.

Munich, May 2012

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Table of contents

Introduction 1

A typology of possible takaful solutions – Clarification of terms and conceptions 3

Deconstructing qard hasan 9

Suggestions regarding a standardisation of retakaful 14

Aspects of retrocession in takaful 20

Questions regarding the essence of windows operations and the wakala model 24

The takaful idea and its role in the transformation of Middle Eastern societies 28

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A typology of possible takaful solutions – Clarification of terms and conceptions1

The features that render takaful (and retakaful) distinct from conventional (re)insurance are often cited and used interchangeably: takaful would be characterised by risk sharing (as opposed to risk transfer in conventional business), pooling and mutuality (as opposed to bilateral relationships), and by tangible calculation as opposed to intransparent business models. Let us briefly analyse and define these terms:

1 Pooling

Technical dimension

Pooling in the technical sense is not necessarily identical to risk sharing or to carrying each others’ losses. It is in essence about transforming the risks by combining them in one pool or, if more favourable, into different sub-pools, using the law of large numbers, homogenisation and diversification effects to minimise the risk-mitigation costs per unit of risk (or say: per participant). It requires skills and knowledge in risk assessment and prospective under-writing to do so, but it does not necessarily require the application of risk modelling. It is especially needed in general business, with its much higher diversity (as compared to family) regarding lines of business, run-off periods, frequency, severity and possible risk correlations.

The pooling effect would imply that costs of risk mitigation are lower for each participant than they would be without pooling. But they are not (necessarily) the same for all participants. The principle behind it can be put like this: ethical and economic reasons require that participants pay for each others’ misfortune, not for poor risk selection. In the long run, every participants’ fund is to pay for its expected claims ratio, while costs for vol-atility reserves are minimised by the large number. It does not necessarily imply cross-subsidisation.

The scholars’ view

This cross-subsidisation, however, is the essence of the more moral or spiritual understanding the scholars tend to put behind the pooling-concept2. The requirement of the scholars is not to pay out individual profit commissions or surpluses to some participants, whose accounts are profitable while the overall fund is in deficit. While an agreement to such a stipulation is indeed proof of a mindset of solidarity and brotherhood, its economic repercussions

1 Most of this text was published in 2011 as part of Munich Re’s General Retakaful Manual.2 See the June 2011 resolutions of the leading scholars.

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cannot be easily predicted. This mindset can render a fund more stable in times of misfortune. But if the possible participants behave in a slightly more opportunistic manner, i.e. like buyers (and this is generally the case in retakaful), it leads to anti-selection in the fund. And in any case, the question comes up how and to what extent differentiated pricing can be done if such solidarity is imposed.3

For the following typology, the term “pooling” will be used in the narrower sense of direct pooling, meaning setting off one participant’s surplus against another participant’s losses and thus paying each other’s losses.

2 Risk sharing and risk transfer – Two sides of the same coin?

Risk sharing is another central feature. The idea behind the legitimacy of takaful is that the takaful operator proper is supposed not to carry any risk at all, but the participants pay all the claims (plus the wakala fee) among themselves. In fact, this feature is not as differential as it might appear. Every insurance portfolio is meant in the long run to sustain all the losses and costs of the insurer, otherwise the insurer will go bankrupt. Deficits of the port-folio as a whole will be borne by the insurer only over a limited period. Losses of an individual account have to be borne, and only this renders the service a useful insurance. Interestingly, the same function is assured in takaful via the qard hasan mechanism. It is the very basis of granting coverage and security, but at the same time qard hasan connects the participants’ fund with the shareholders’ fund in the way of communicating pipes – it blurs the careful separation of both funds, and the differentiation between takaful and conventional techniques becomes virtually obsolete.

Qard hasan (to the extent it is drawn) connects the two funds and together they fulfil the functions that take place within the portfolio of a conventional insurer. It appears that to the extent the participants behave like consumers (i.e. opportunistically), the takaful system converges towards the conven-tional in term of cash flows. The most important question arising out of this conclusion is how, if at all, the takaful companies can in practice keep themselves different from conventional insurance.

A way to maintain a real economic difference is to stipulate that clients can-not leave a fund as long as it is in deficit, i.e. as long as there is qard hasan outstanding. There is still a credit risk, i.e. the risk of insolvency of the partic-ipants, but definitely more risk – and risk capital costs – remain with the par-ticipants. This is, though, only applicable in closed and named funds, not in mass business. And, again, it is not new to the conventional world, since it comes close to structured financial reinsurance business.

3 This imposed cross-subsidisation is reminiscent of the European stipulations that forbade gender-differentiated calculation of life insurance tariffs, which are equally inefficient in economic terms.

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Tangible calculation

The initial approach of shari’a models may be called “tangible calculation”. In a tangible calculation, the qard is paid as it occurs, be it low or high, while in the modelled approach qard is prepaid as it is expected. Surely, the tan-gible approach represents more closely the hand-to-hand (yad bi-yad) rule and assures clear calculations, while the modelling approach appears less transparent. But how are we to apply a tangible approach to very rare but severe risks that need extensive reserving and which may change their probability through technical progress more frequently than they actually occur? The advantage of the tangible approach in transparency is dearly bought by limiting the application to complex and long-term risks and portfolios. The task is to use the advantages of modelling and make sure that the necessary transparency is observed. This is the task of the discus-sion between actuaries and shari’a boards.

3 A tentative takaful typology and its results

Three dimensions determine the typology of takaful business, independ-ently of the model applied:

− Tangible calculation versus modelled pricing: Ex-post real figures versus prospective estimations, annually adjusted.

− Pooling versus individual calculation: Figures or reserves of sub-pools are directly set off against each other or not.

− Risk sharing versus risk transfer: Risk sharing means that the fund cannot be dissolved or left by the participants as long as it is in deficit, whereas with risk transfer the participant is free to leave the fund any time.

Risk sharing Risk transferTangible Modelled Tangible Modelled

Pooled Type 1: (Classic)

Type 2 Type 5: Classic family

Type 6: 5 with wakala

Individual Type 3: (Tangible financial deal)

Type 4: (Structured financial deal)

Type 7: Mudharaba/ ju’ala

Type 8: Calculated wakala

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A Risk-sharing types

− Type 1: Tangible – pooled: Classic theoretical (ideal) variant of takaful

− Type 2: Modelled – pooled: Same as 1, with one-year predictability of pooling contribution (= via reserve)

− Type 3: Tangible – individual: Financial deal (individual pool, risk sharing between periods of one client, not of different clients)

− Type 4: Modelled – individual: Same as Type 3, but structured by pro-spective pricing

B Risk-transfer types

− Type 5: Tangible – pooled: See surplus redistribution in family retakaful approach. Mudharaba/ju’ala is an appropriate retakaful model for this.

− Type 6: Modelled – pooled: Same as 5, also possible with wakala (mod-elled fee)

− Type 7: Tangible – individual: Classic mudharaba deals

− Type 8: Modelled – individual: Same as Type 7, with calculated wakala

3.1 Risk transfer and modelling

Tangible calculation is preferable where possible from a shari’a point of view to avoid unnecessary gharar. But modelling becomes necessary in most kinds of risk-transfer business (to enable feasible pooling and individual predictability of treaty results). It is in particular a prerequisite for business with low-frequency and high-severity claims, where reserves play an important role. This is at the same time high-volatility business. Therefore, family takaful is an exception where tangible calculation can work, although mortality tables already provide a fine modelling basis. Retakaful, with its affinity to risk transfer, should largely be modelled.

3.2 Where risk sharing flourishes

Following experience and the principle of insufficient reason, one should assume that participants in takaful pools behave more or less in a rational and “average” way for most mainstream products, creating risk transfer situations.

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Risk sharing can only be assumed in three cases:

− When affinity groups are turned into takaful pools. These are groups that have not been formed for the purpose of taking out takaful cover (e.g. associations, regional and social conglomerations like village popula-tions and tribes) and will thus not exit the group just because this cover does not turn out to be directly beneficial to an individual. Such groups nearly always show a degree of social transparency and thus often also have some sense of solidarity. In the prisoner’s dilemma well known from game theory, the coordinating principle would be “blind trust”.

− If they have a discernable common interest and/or a person or institution that is in charge of coordination between the participants. This could be the case with companies with common ownership, i.e. holdings, where one master policy can be taken out by the holding.

− All kinds of social insurance or public (public-private) schemes, usually involving sovereign guarantee for repayment of the qard hasan. In that respect, takaful is the ideal tool for Islamic states and international organ-isations for setting up funds and mitigating risks that would need to ultim-ately be borne among them, like natural catastrophes, climate change or infrastructural development.

It appears that these genuinely appropriate and ethically desirable applica-tions of the takaful idea are by far not exhaustively developed yet and can be a great source of sustainable growth for the industry.

Risk sharing Risk transferTangible Modelled Tangible Modelled

Pooled Type 1: Retail affinity groups

Type 2: Holdings and public schemes

Type 5: Classic retail (family) takaful

Type 6: Classic family retakaful

Individual Type 3: Financial retakaful

Type 4: Structured financial retakaful

Type 7: Mudharaba/ ju’ala, general business

Type 8: Calculated wakala general business

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4 Summary: The takaful quadrant

It is not the model or the treaty that primarily define whether and how busi-ness is different from conventional insurance. It is the mindset and behaviour of the participants. In stressing the crucial role of mindset and morals, the scholars are absolutely right, also economically. The question is just whether insurance solutions with a more commercial mindset behind it, but which are still maintaining other shari’a compliant features such as investment, have to be considered illegitimate. Mutual and social features are surely more manifest in retail mass business and in personal lines, while in indus-trial and mega risks mutuality is hard to be implemented even with the best will. Therefore, these two dimensions are assumed to create a preliminary map of possible Islamic insurance solutions.

Economic orientation

PPP schemes

Social/Micro (e.g. health) schemes

SME/ Commercial

Mutuals, PI clubs

Takaful retail

SMEProject business

Conventional retail

Market segment Industrial

lines

Risk carried mainly by SHFRisk carried mainly by PTFNew solutionsConventional Replaces conventional

Commercial lines

Commercial

Social/benevolent

Co- operative

Retail lines

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Deconstructing qard hasan4

The concept of takaful and retakaful is risk sharing, which may be under-stood as the participants paying each other’s losses. Qard hasan means that the (re)takaful operator pays the participants’ losses – at least tem-porarily. Qard hasan obviously is a breach in the system of the risk-sharing concept, but it is also an obstacle to a concept of takaful that parallels it to insurance – since the qard is to be posted in the accounts as a loan and not as a loss. Qard hasan is thus a constant source of doubt to accounting and regulatory bodies when assessing the nature of takaful; it is neither men-tioned in any of the fatwas on which the takaful system is based nor prom-inently dealt with in the respective AAOIFI standards, and is yet crucial for solvency and the main service demanded by retakaful operators. The qard hasan concept obviously deserves close examination and is increasingly receiving the attention it deserves. In the following, we will try to analyse the repercussions of the different technical interpretations of qard. In the second part, we will review the technical application in retakaful. We con-centrate here on the financial and partly shari’a nature, fully aware that the notion bears a spiritual content as well.

Categorising qard by obligatory nature of payment and repayment

Articles on the nature and handling of qard concentrate on what it ought to be. Is it obligatory? Is it precedent to participants’ demands in the case of bankruptcy? Is it, therefore, to be considered an asset or a loss? Is it an unlimited or a limited facility? There is no definite single answer to this, simply because legally (not economically!) it is a peripheral, accidental, even alien feature of the takaful model, and thus little guidance is available on its intention in takaful. Let us therefore for the time being assume that there is a choice of different kinds of qard to be featured in a model, subse-quently creating different kinds of (re)takaful. We undertake to categorise it in the following according to how obligatory its payment is. The next cat-egory to examine is then the obligatory nature of its repayment.

1. Qard is not a part of the takaful model.

That means that deficits are made good by the participants in two ways:

a) By financial injections they give individually or as a community following claims

b) By avoiding deficits altogether, whereby participants who suffer losses while the fund is (temporarily) exhausted simply forgo their claims

4 This text was published in the September 2011 edition of Middle East Insurance Review.

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The former case is a pure mutual, with limited practical viability, although it is apparently applied in Sudan. The latter is not insurance at all and does not really serve the aim of protecting the participant against misfortune.

2. Qard is voluntary in nature and amount.

From the perspective of protection, a real voluntary qard facility is like having no qard facility. As under 1 b), there is no reliable protection for a particular participant when the participants’ fund (or the operators willingness to pro-vide more qard) is exhausted. Those joining such a fund must have other (e.g. social) reasons.

3. Qard is obligatory (or made obligatory), but it is a facility limited in amount.

In the case of obligatory qard, as considered now in Malaysia, the solvency and security of the takaful cover can be assessed and the participants are insured, but, if the qard amount is limited, the retakaful operator is protected against downward scenarios and bankruptcy. The operator may have a receivable towards the fund afterwards, the fund has no right over and above the qard facility towards the operator. We deem that this is already (re)insurance, with limited liability.

4. Qard is obligatory and covers the whole insurance exposure assumed.

In that case, the operator can be liquidated in order to pay the claims of the participants, and thus the qard is automatically subordinated to the partici-pants’ demands. Although it is still possible to see the qard as a receivable of the shareholders towards the PTF, here the participants’ level of protec-tion is comparable to what a conventional insurer offers.

We hold that at least examples 1 and 2 are (although not unheard of also in the conventional world, e.g. in friendly societies) limited to social niches, where taking out cover is not the main motivation for the participants to unite and where they accept that they may get nothing against their dona-tion even in the event of a legitimate loss event. Except for Sudan, it had not been attempted to market it as a mass product. These earlier two options are also definitely not applicable to retakaful, where the cedants are takaful operators. These are not only unlikely to be socially committed to their com-petitors in the same retakaful pool; they have, most importantly, a responsi-bility towards “their” participants. They need to have calculable and reliable security and coverage for the pools they manage

As to options 2 to 4 for payment of qard, there are repayment options. The qard can be

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− a liability that falls due with cancellation of the policy as an obligation to all or some (named!) participants;

− an obligation on participants to stay in the fund until surpluses have repaid it; − forfeited by the shareholders, rendering it tantamount to a loss. If the latter happens without any remuneration, it may happen out of a spirit of solidarity. If this is a part of the business model and somehow directly or generally priced in, we are in the risk-transfer business.

Economic role and cost of capital

It follows from the above analysis that at least in retakaful, and in many applications of takaful, capital injections in the event of a deficit must eventually be an obligation of the operator. Repayment can also be obligatory or, by contrast, forfeiture can be automatic. But in both cases the function-ing of the business model (in retakaful) depends on it being clearly stated which option applies. If repayment is obligatory (i.e. part of the contract), we are in financial reinsurance. If it is automatically forfeited, we are in risk transfer. At least in the latter case, however, the shari’a features and inten-tions of qard hasan do not really fit.

An even more delicate issue with the qard construct is that any return on it above the principal is by definition riba, irrespective of whether it repre-sents a time value of money or not. But if qard hasan is a regular, virtually obligatory and substantial payment, the operators must raise risk capital to cover possible qard, and the security rating of a retakaful operator depends on the amount provided (see the chart below). And that means that in one way or the other a return on this capital will be expected, otherwise no cap-ital can be raised. If the return is not calculated under cost of capital, it will be taken into account in other parts of the operator’s income, as in the fees, or the overall return of the business has simply to be high enough to make good for all expenses including cost of capital. But this does not seem to be a transparent way of calculation by retakaful standards.

The suggested Malaysian regulation intends a clear calculation, but by leaving the liability risk – including its volatility – to be covered from the participants’ fund and operational and expenses risk to be borne by the shareholders’ fund. But the qard mainly covers liability risks and, according to these regulations, it is to be paid from the shareholders fund. How this can be applied in particular to retakaful operators, where expenses and operational risks are small compared to the liability risk, needs in our opinion further clarification.

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In the usual hybrid models, the operator receives a wakala fee for managing the fund and a mudharaba share for investing the money in the fund. In what we may for the time being call the risk transfer case (i.e. high-volatility business), the functions of the operator are threefold: managing the fund, providing security, and investment. Managing the fund basically means selecting, balancing and diversifying the risks in the fund, so that the risk capital needed for providing security is minimised. Providing security means providing shareholders’ capital subject to receiving a share of the returns of the business. This formulation already shows that the model of choice for that second function seems to be the mudharaba model. How-ever, one may need to consider that the mudharib in this kind of business would be the operator and the rabb ul-mal are the operators’ shareholders; given that these roles should not be united in one company, musharaka or wadi’a may be more suitable contract forms.

Risk tolerance

Mean

Green area represents 0.5% of the area below the total loss distribution

Total loss distribution

VaR (99.5%)

175% · VaR (99.5%)

Area where qard facility defines security level

BBB AA to AAA

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Summary: Replace qard hasan in retakaful by risk transfer mudharaba/musharaka

At the end of the day, the participants de facto define how the system works. If they opt for no real security, capital injections are dispensable and then the qard is really qard hasan. But then they have no sufficient replacement for the positive economic effects of (re)insurance.

If they expect capital injections but accept to repay it, whether individually or as a group, we can speak of qard, and we are technically close to finan-cial reinsurance, with all its advantages and limitations. Due to the remain-ing credit risks and problems of legal enforcement, for most areas – say, risks with a return period of a couple of years onwards – this does not seem practicable.

If capital injection is required in a virtually obligatory way, but repayment is not obligatory, the qard or qard hasan concept no longer reflects the eco-nomic reality. To nevertheless cling on to the concept leads to a number of undesired results: hiding costs of capital; not earning cost of capital although that is needed and deserved; understating security and solvency although it is in fact dearly bought and dearly needed in competition; and the con-fusion arising on the accounting side on the nature of qard as a receivable. Qard hasan is an honoured concept, and its central role in defining the whole system has again been shown above. But for business of even modest volatil-ity, its applicability in the understanding of a voluntary and return-free loan comes up against its limits.

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Suggestions regarding a standardisation of retakaful5

The following is a summary of a presentation given at the 6th World Taka-ful Conference in Dubai on 11 April 2011. It was held to explain the general retakaful manual launched by Munich Re on the same occasion; the manual, in turn, is part of a broad mobilisation effort towards standardisation in the industry, the need for which is widely and unanimously felt.

The presentation consisted of the following parts:

1. The relation of risk sharing/pooling, the retakaful model and pricing

2. The general typology of takaful solutions (an issue we dropped in the article below)

3. Requirements for an acceptable retakaful standard: clarity and proced-ural applicability.

The reality of the retakaful world and obstacles to its growth

Most of the reinsurance taken out on takaful is still conventional, although there is formally no longer any lack of capacity. The requirement often heard from the markets when offering retakaful is to “just change a few terms, as we always did”. Retakaful operators are thus under severe pressure to stream-line their product towards conventional reinsurance. The most probable reasons for this are:

a) Conversion costs and a need for education and training due to new pro-cesses and techniques.

b) Retakaful seeks to replace reinsurance in most cases, and the demand for reinsurance is a demand for risk transfer. Retakaful, on the other hand, is meant to be cooperative and based on the concept of risk sharing. Two conclusions can be derived from this:

− As long as the dilemma of risk transfer and risk sharing is not solved, no standard can be established.

− A standard wording alone is not enough to break the market’s resistance. The standard has to be explained to a community still familiar with conventional insurance. And retakaful has to fit in with the existing pro-cesses in the reinsurance markets without simply bowing to the forces that tend to render it a copycat version of conventional business. The

5 This text was published in the July 2011 edition of Islamic Finance News.

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motto is: better to have a manual without a wording than a wording with-out a manual.

The three axes that define the retakaful mechanism

Sharing is considered to be the core and differentiating idea of takaful, and the three facets of sharing: risk sharing, surplus sharing and loss sharing are, as far as we see, used quite interchangeably. In the following, technical and distinct definitions are suggested.

1. Risk transfer vs. risk sharing

The following definition of risk sharing is proposed in the Munich Re manual:

“Risk sharing means that in the long run claims are paid by the community of participants, the company providing qard hasan for an intermediary period only” (this is, by the way, also true of all insurance companies that do not want to go bankrupt).

The decisive question for the definition is: are the participants obliged to stay even if the pool is in deficit, or can they leave? If they can leave the fund in a deficit situation, the operator has to provide for irrecoverable qard hasan in his pricing. Otherwise the shareholders’ fund will bleed out.

In other words, if qard is not an accidental but substantial feature and a main service in the treaty and if there is no contractual obligation to pay it back, it has to be regarded at least partly as a loss. And in this case, a mathematical risk-transfer test would prove that there is risk transfer. And if so, the irrecoverable qard hasan has to be priced in, probably into the wakala fee. The mathematically simplest way of doing so is shown in an example: a portfolio has an average loss ratio of 80% and a historically minimum loss ratio of 65%. Since claims have to be paid, the operator can, with this loss ratio, never earn more than 20% to cover his costs and profit margin. But he can earn less, namely when he has to give out surplus in good years where no qard is outstanding. So, he strives to set the wakala fee in a way that no surplus redistribution occurs even in the best of years. In this case, the respective fee is 35% (100% – the lowest loss ratio observed).

In short, if risk transfer according to the above definition is given (no con-tractual obligation to stay in the case of a deficit), the wakala system does not lead to surplus sharing at all. It even tends to rule out surplus redistri-bution.

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Compare the two following charts:

Case 1: Contractual obligations or negligible qard hasan (risk sharing)

Case 2: Risk transfer, but still wakala

Management expenses

Reinsurance/Retakaful

Reserves

Takaful fund

Shareholders’ fund

Qardhasan

Wakala fee (e.g. 20%)

Underwriting profit

100% of surplus

Contribution

Participants

Islamic investments

Investment profit

Policy benefits

Surplus (Deficit)

Management expenses

Reinsurance/Retakaful

Reserves

Surplus (Deficit)

Takaful fund

Shareholders’ fund

Qardhasan

Wakala fee (e.g. 35%)

Underwriting profit

100% of surplus

Contribution

Islamic investments

Investment profit

Policy benefits

Participants

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2. Pooling

Pooling, on the other hand, can be defined as: “Participants pay for losses another participant has sustained”.

This can happen when the losses are directly deducted from the other participants’ surplus. This is probably what one has in mind when talking about risk sharing and a spirit of solidarity. But, in case the possible losses are higher than the available surpluses and even higher than the reserves in the participants’ fund (high volatility business), the pooling automatic-ally takes place via the shareholders’ fund, as in conventional business. And more importantly, by balancing the results of different participants, gains are achieved by using the law of large numbers and diversification effects. These smoothing effects are the very basis of the business model of reinsurers and the added value they offer. They are automatic mathe-matical effects depending on correlations, and they happen independent of whether the pooling is done directly or indirectly and whether there is a spirit of solidarity – no matter how laudable it may be – behind it or not. Pooling as a mathematical method does not really differ from conventional business.

3. Risk modelling

The method behind this is risk modelling, as opposed to tangible calcula-tion. The relevance of risk modelling in shari’a terms seems to be rarely taken into consideration. Tangible calculation is the method favoured by shari’a wherever possible, due to its clarity and lack of possibilities to hide undeserved earnings. It is ideally represented in historic schemes where contributions are collected as losses occur, without an advance contribu-tion even being calculated. In most modern mass business transactions or in low-frequency and high-severity business, however, this is not possible. There must be a pre-calculation because losses are either too frequent to be paid through case-by-case collection or so high that reserves need to be built up over time.

Now, when doing risk modelling, a retakaful operator (and reinsurer) builds segments of the portfolio (sub-funds, one may say), assesses their respective loss distributions, and calculates the diversification gains by balancing the segments against each other. In other words, it pools and manages the pool. And it sets the contribution and makes sure it is sufficient to cover all the losses. This means that the participants share the risk among themselves.

To summarise: what happens at the technical level in reinsurance and retakaful is not much different, in particular not in the market segments of large and rare risks, where reinsurance cover is needed most. The only

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difference is that for these segments tangible calculation is not feasible and other techniques need to be used. No matter what model is applied, this fact remains a reality. The behaviour of participants largely defines whether there is risk sharing or not – not the model applied.

It would be worth keeping in mind the importance of risk modelling when striving to exclude excessive gharar and exploitative practices, the avoid-ance of which is still the intention of takaful and retakaful alike.

The procedural part of standardisation and consistency

One of the obstacles to the rapid spread of retakaful – and not the least important one – lies in the procedural requirements of the reinsurance markets and probably in an insecurity about what makes a retakaful treaty shari’a-compliant. The placement of reinsurance, whether done directly by reinsurance departments of the cedants or by brokers, is a highly optimised and automated process (“off the mill”) and at the same time customised in the sense that no two reinsurance (or retakaful) treaties are ever really identi-cal. During negotiation, quotations, options, letters, clauses and exclusions are changed and exchanged in the process, possibly rendering the final result quite different from the first offer. The process is complicated even further by the system of lead reinsurers and following markets and the requirement of differential terms expected to be applied when reinsurers and retakaful operators are on the same reinsurance panel. If these proced-ural (cost-relevant) aspects are not addressed, the markets will, even with the best of intentions, hardly be able to apply retakaful broadly.

In our view, procedural requirements for a standard comprise the following:

1. Changing of conventional clauses only where necessary

2. Changing to a wakala treaty (a request by shari’a scholars)

3. Defining the role of investment separately

4. Providing a clear definition of the type of treaty (pooled or independent)

5. Predictability of the treaty results irrespective of how the rest of the retakaful fund performs

6. Standards for halal risk screening

7. Fatwa with an exhaustive list of non-shari’a-compliant clauses, so that underwriters can be sure that the treaty is compliant as long as the clauses on the list are not used.

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In sum, the suggested approach is modular. Shari’a compliance is to be assured by applying a limited number (e.g. five as below) of wording elem-ents or modules, which are approved by all the leading scholars. The other parts of the wording can be changed without any effect on compliance.

The motto of the original presentation was: “just by calling a horse a bird, it does not start to fly. This having been accepted, however, it may still be a good horse.” In technical terms, retakaful is not always as different from reinsur-ance as originally thought. But it is and ought to be different, and by defining more closely what needs to be kept apart and what is just an unnecessary complication to marketability, retakaful may be more successful and escape the streamlining forces that wanted to have it simply as a conventional copy-cat for quite some time.

Preamble – Definition of basis and model (as already done)Pricing elements – Map wakala with conventionell PC statement

– Define qard as hiba – Clarify non-refundable CSR – Investment fee per total fund

Legislation – State shari’a base and arbitrationAll interest-bearing articles – Penalty interestHalal screening – Principles (threshholds for alcohol, etc.)

– Follow-the-fortunes clause

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Aspects of retrocession in takaful6

To our knowledge, no specific shari’a rulings have been published on retro-cession. And apparently with good reason, because there are other burning issues to decide on, and the situation in retrocession is essentially no differ-ent from that in retakaful. Retroceding to conventional companies means shortening the shari’a-compliant value chain by handing over part of the shari’a-compliant contribution to the conventional economy. It is thus tanta-mount to a reduction in the volume of the Islamic economy and is therefore only allowed in connection with dharura. And the solution to this, we keep hearing, is to expand the value chain by setting up new retakaful companies or pools. In a word, by increasing the available shari’a-compliant capacity by means of raising new shareholder capital.

That is the general opinion, but it is only a part of the story. Let us ask two questions. First, what do we need retrocession for? Second, is the only alternative to conventional cessions more shari’a-compliant capacity?

Reasons for taking out retrocession

− Expanding capacity

− Using synergies/exchanging know-how: Domestic or regional reinsurers team up with international ones in order to combine their market access with the international partner’s know-how and share the busi-ness.

− Diversifying risks: This is a particularly problematic issue because for retakaful operators achieving geographic diversification largely implies mixing their portfolios with regions where only conventional insurance exists.

− Intra-group cessions (applying also to retakaful/reinsurance): Interna-tional groups (and most of them now have takaful subsidiaries) widely use this to exploit their scope for diversification and for synergising without unduly impacting their risk capital.

Particular difficulties to achieve this in the takaful world

The above means that the need for retrocession goes beyond pure capacity – and will thus not be removed by establishing pools. Let us go through the four points above:

6 This text was published in the March 2011 edition of Middle East Insurance Review.

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Expanding capacity

When bidding for large risks, takaful operators are at a disadvantage com-pared to conventional competitors if their retakaful partners are limited to shari’a-compliant retrocession capacity only – therefore one can argue that dharura cases are given. But firstly, we doubt that takaful companies would be well advised to seek their growth primarily in competition on large risks. Secondly, the projects in this segment are also offered to the conventional industry and creating additional shari’a-compliant capacity will have a direct impact on prices. Assuming that takaful operators have not yet built up specific expertise in these segments, the chances are high that they will get larger risks primarily via the price. This means that addi-tional capacity, if not supported at the same time by enhanced expertise, just draws the operators into undesirable business. And thirdly, the neces-sary risk capital becomes increasingly scarce and will be relatively rarely used, i.e. it is too expensive. And that may be the reason why earlier attempts to create pools were unsuccessful and why such attempts may be doomed going forward.

Exchanging know-how

This already led us to the second point: know-how. Obviously, earlier attempts to create shari’a-compliant capacity for large risks have not neglected this issue, and included the concept of bringing in underwriting and handling expertise from the conventional world. Why this concept failed cannot be judged here; perhaps because the conventional players saw no gain in it that could outweigh their efforts to enter into the unfamiliar retakaful envir on-ment. And the business would still come to them the conventional way.

Diversifying risks

Limited geographic diversification is even harder to overcome. Giving away takaful contributions to conventional carriers is one issue. Being able to accept retrocession from outside the Islamic world in return is at least as much of a challenge to retakaful operators. Thus, the dharura permission for retrocession can become a one-way process that leads to a drain in contri-butions without any balancing effects in return. Of course this can and will change with time, since the Islamic world is a vast, diverse and rapidly devel-oping region and Islamic finance is flourishing in a number of Western mar-kets. But for the time being, this is a limiting factor to the relative efficiency of the industry.

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Intra-group cessions

Internal retrocession and its extent are by nature internal issues. But it is certain that, in connection with allocation of capital and repatriation of profits, global groups have to observe an additional layer of rules and limita-tions for their Islamic subsidiaries in contrast to conventional subsidiaries. And the involvement of such groups plays an important role for the transfer of capacities and know-how to the takaful industry – both dearly needed.

Methods and strategy for compliant growth

All these points have a common denominator: the (re)takaful industry, at least as far as it wants to move beyond the area of personal lines, needs to connect with the conventional global industry and its resources. We believe there is no medium-term alternative to this. But this connection, if not tackled properly, may possibly spoil the very intention of takaful, which is to create a distinct and alternative insurance industry. The simplest form of this connection, namely conventional retrocession on a dharura basis, is a “lesser evil” with little gain in return and should be replaced as soon as possible. Such attempts at replacement, as mentioned, have already been made but have not yet taken off. Conclusions have surely been drawn with a view to making this more feasible, but even then the tools available to the takaful industry for docking onto the international resources are limited and complicated to establish. So, we at Munich Re have been working internally on a fully shari’a-compliant and relatively manageable solution, which we plan to outline in a separate document soon.

Collaborating with conventional?

All the points mentioned can add a new perspective to the development of the industry. The takaful industry obtains access to capacity, diversifica-tion and expertise without reducing the volume of the Islamic economy, i.e. without dharura restrictions. Clearly these ideas have to be developed and approved, and there is no harm done in trying to collect more standalone shari’a-compliant capacity at the same time. The hard fact is that the con-ventional industry is much larger and much needed and does not have to go to any great lengths to accommodate retakaful partners. So the key is to address their concerns without spoiling the essence of takaful, which is shari’a compliance. The danger of mistakes and misunderstandings is still high. But it becomes easier and better the more often it is applied, while the raising of new standalone retakaful capacity becomes more difficult and less efficient with every additional attempt. And the alternatives are either a takaful industry, strictly separated but also confined to its limited means and always at a disadvantage vis-à-vis developed conventional

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competitors, or an endless chain of dharura decisions, in the end rendering the concept hardly distinguishable from the conventional competitors.

The industry has to use its knowledge to stand its ground and build shelters against the streamlining forces of the giant conventional world, while inter-acting with this conventional giant. And the techniques to build these shel-ters are being developed right now.

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Questions regarding the essence of windows operations and the wakala modelThe term “windows operations”, i.e. Islamic finance products (in our case: takaful) within a conventional company – in whatever form – sounds as if it is a half-way, half-hearted or opportunistic solution, at best a stop-gap phase until standalone operations can take off. Irrespective of the partly moral/spiritual understanding, there are arguments for both approaches (windows and standalone solutions) which are often discussed without reaching a final conclusion. Different regulators have taken different stances in the matter. Malaysia requires a full standalone licence in takaful while allowing windows in banking; Pakistan recently allowed takaful windows operations on the condition that the head(s) of windows units and their departments are separate from those of the conventional depart-ments. This paper is designed to put these arguments into the perspective of a functional analysis, thus helping to prepare solutions for different circum-stances and targets.

Wakala as the “natural-born window”?

There is another perspective from which one can look on windows opera-tions. Let us consider that the most basic feature of takaful is the separa-tion of participants’ and shareholders’ funds, a separation most stringently applied in the wakala model. There is no doubt that the participants’ fund is the mutual fund in which the shari’a-compliant risk transformation takes place and that it has to be separated from conventional business. But this separation is already intrinsic to the takaful model. And what is then the specific Islamic feature of the shareholders’ company, which is the takaful operator proper? From a shari’a point of view, its function is to administer and manage the participants’ fund as wakeel, whereas from a management view of the participants’ fund, this wakala contract can be seen as a kind of outsourcing. A wakeel does not need to be Muslim or Islamic, he just has to observe the proper processes, and an outsourcing partner can be chosen on the grounds of pure efficiency. In other words, is the takaful model with its fund separation not naturally made for outsourcing the task of fund management to an economically appropriate partner, e.g. to a conventional insurance that has already invested in set-up, licensing and HR? One might even say it is economically a waste of the effort put into separating the funds if it is not used for synergising with the existing setups and for outsourcing the management to the appropriate partner(s). From this perspective, the said reservations against windows even look surprising.

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Pros, contras and their internal relation

The arguments one usually hears against windows are, broadly speaking:

− Risk that there is lack of staff dedicated (functionally and mentally) to the takaful operations

− Operational risk of spoiling the proper processes by untrained conven-tional staff and particularly of blurring the separating line between takaful fund and conventional business

− Doubts regarding the sincerity and commitment of the parent of the win-dows operators including – in the extreme case – understanding by buyers of “doing halal with the right hand while doing haram with the left”.

The arguments in favour are mainly:

− Synergies in risk capital

− Use of the existing setup and staff (including their expertise)

− Use of the conventional distribution network

− Use of the already established conventional brand

At first glance, it may appear that the counterarguments tend to stress clarity and sincerity, i.e. somehow the spiritual side, while the points in favour of windows are more of an economic nature.

Standalone Windows Remark OverallOperational + No ring-fencing

problem+ No ring-fencing problem

Due to obligatory fund separation

+ Windows

Procedural + No lines to be blurred – Lack of re sources/ expertise

– Compliant processes can be spoilt + Expertise (if as in con-ventional) available

Trade-off, pro-vided takaful-trained staff is available

Depends

Risk capital

Low efficiency Synergy Clear strength of window

+ Windows

Costs + No ring-fencing costs – Set-up costs

+ No set-up costs – Doubling of apparatus

Balance depends on actual organi-sational structure

Depends

Reputa-tional

+ Clear and committed – New and untested

+ Established brand – Inconsequent and lack of commitment

Depends on how seriously ban of conventional is viewed

Depends

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Form and content

On balance, it appears that the clearest advantages of windows operations lie in the risk capital and set-up costs and, as mentioned above, there is no operational downside to this due to the automatic fund separation intrinsic to the takaful model. Only when the windows operations become so volu-minous that the capital to cover these liabilities outstretches the available shareholders’ capital from “clean sources”, this synergy effect begins to shrink.

The balance on the reputational side ultimately depends on how the haram nature of conventional insurance is viewed. For purists, someone who does conventional business, albeit distinctly separate from takaful business, may be unsuitable as a business partner. Those who view conventional insur-ance as a helpful concept with flaws may find that windows even combine the best of two worlds. The same holds true of and is directly applicable to distribution networks and marketing, since it depends on the values and understanding prevailing in a given market.

To arrive at a conclusion on the procedural side, differentiation is needed, preferably by enterprise functions. Which functions do not require takaful-specific knowledge at all, which are more sensitive, and how can the pro-cedural risk best be addressed? Can the procedural separation between a company and its window require structures and resources that in terms of expenses come close to the set-up costs of a standalone unit?

But there are more questions to the procedural aspect: Is it in fact the best and only solution if, like in the Pakistani rules, the heads of takaful window departments are separate while they share the same staff with their con-ventional counterparts? Are procedural mistakes not arising on the pro-cess-owner level? And, what if a standalone takaful operator cannot take advantage of its (expensive) separate structure because there are no staff with takaful experience? Finally, and bearing in mind that many of them are subsidiaries of conventional groups and draw on shared services from parents and subsidiaries just as windows operations do, what is the content of the differentiation, apart from the legal form?

General answers can in our opinion not be given easily: one has to look at the specific situation in detail. One might plausibly assume some points, for example that accounting separation should not be a procedural and expense issue, given the flexibility of today’s IT systems and provided there is sufficient training of the accounting staff. Compliance in product develop-ment or underwriting (both for pricing and, in general takaful, risk selection) would seem more demanding, but then again: standalone or subsidiary oper-ators are not automatically immune to deviations and need to put takaful-

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specific expertise and efforts into knowledge management and a shari’a compliance governance structure, just like (or nearly like) windows operators. Investment clearly needs to be shari’a-compliant, but luckily the respective investment tools are generally more advanced than the insurance techniques. Finally, one of the largest synergy potentials, as well as perhaps the largest procedural compliance risk, can be expected in the distribution system. A large agent network is difficult to train and monitor regarding shari’a com-pliance. It is a challenging task in Muslim majority societies, and even more in the Western diaspora.

Summary

− There is no ambiguity in the point that takaful funds need to be ring-fenced from conventional business. But through the basic takaful prin-ciple of fund separation, the wakala system makes sure this is done in standalone as well in window operations, and without particular costs involved. As mundane as it may sound, for an IT system a takaful fund is basically just another ledger, like any line of business separated for con-trolling reasons.

− Procedures are a more critical issue, and the respective risks in windows operations have to be taken very seriously. Standalone companies are likely to be less exposed here, but even they have to put efforts into governance (from the shari’a board via shari’a compliance officers to shari’a audits) and controlling. The risk lies in employing unqualified or insufficiently trained staff and a lack of management awareness, which can happen with stand-alone operators, in particular if they outsource part of their wakeel duties. The risk is always present when using shared services, and this takes place between a subsidiary and its parent as well as within a window operator and its conventional framework.

− Thus, the economic advantages of running takaful business in cooperation with conventional operations, whether by windows, subsidiaries or out-sourcing/partnerships, are obvious and essential. The procedural risks on the other side of the scales surely have to be addressed, but they are not automatically excluded by choosing a certain legal form, e.g. subsidiary. One needs to look at the actual processes, structures and knowledge in place, irrespective of name and form. Dedicated staff and management are required by regulators, and for good reasons, but what is certainly always needed when running shari’a-compliant business is knowledge, awareness and proper governance.

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The takaful idea and its role in the transformation of Middle Eastern societies7

Ideas and historic parallels

It has always been accepted that takaful is close to mutual and cooperative insurance. Indeed, a number of takaful companies are members of the international association of mutuals, ICMIF. Similarly, there is a wide-spread view that takaful is best suited to increasing retail penetration. In this process, takaful operators can fill those spaces in the insurance land-scape of the Islamic countries that are filled by mutuals and cooperatives in the Western markets. These spaces are, generally speaking, the rural and peripheral areas, covered by a decentralised network.

Furthermore, there are deeply rooted historic parallels and even connec-tions between the mutual economy in Western countries and Islamic finance. The Western mutual idea appeared within gradually opening and rapidly industrialising societies as a means of ensuring an even spread of capital among a broad middle class and as a counterforce to the concentration of capital – and thus power – in a few hands. It was also intended as a “third way” between Manchester capitalism and socialism, often motivated by a genuinely Christian sense of responsibility which – like Islamic finance – sees God as the ultimate owner of all worldly goods. Although not a purely Catholic idea, this was most clearly and influentially expressed in the papal encyclical “rerum novarum” of 1891.

These intrinsic parallels surfaced in the first interest-free bank, the Mit Ghamr project, whose founder had studied in Germany and observed the mutual economy there. And it was no coincidence that this first Islamic bank of the modern era was a joint venture with the mutual savings and loans bank (“Sparkasse”) of Cologne.

If Middle Eastern societies are now on the brink of a democratic opening, driven by an ambitious, yet threatened, middle class, the tasks ahead are similar. The idea and ideal is that there must be a more even distribution of opportunities and wealth as a requirement for justice and a functioning democracy. In fact, the chances are high that these movements will fail if they bear no real economic fruit for a substantial portion of the population within a reasonable time. Parts of Europe took that path in the 1930s.

Another historic parallel is the transition in eastern Europe 20 years ago and, again, one of the main tasks then was the flanking of the political and social transition with the privatisation of the socialist economical structures.

7 This text was published in the April 2011 edition of Islamic Finance News.

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In Germany, this was done by transferring virtually the whole East German economy into a trust (“Treuhand”) and gradually selling it off to private investors. It was, however, not an aim of this transformation process to strengthen the mutual and cooperative economy. Large Western corpor-ations invested in the buy-out, thus lending their strength and know-how to the transforming economies.

Solving two issues in one go

All historic parallels also contain fundamental differences, and things in the Middle East may well turn out differently, at least in takaful and insur-ance. Strictly speaking, there is no social market economy there and also no broad insurance infrastructure, particularly in the rural areas, be it con-ventional or mutual/takaful, or even social insurance. There is no safety net that enables economically active strata to plan and undertake innova-tions which involve risks. There is little reward for the efforts of small and medium-sized entrepreneurship. And there is little capital and productivity accumulation on the individual level for broad swathes of the population. Finally, the known allocation advantages which insurance sectors normally provide to their national economies are limited to the industrial segments in these countries. In a word, the economic risk management apparatus of these societies is largely dysfunctional.

But, to switch the spotlight to the micro-level, takaful is still, if we may say so, experimenting with its final form, model and mission. The involvement of large investors and the specific structure of shareholders’ and participants’ funds have given takaful its speed and dynamic so far, just as in the European privatisation process. But it has not spread much to rural areas yet and out-side the GCC countries and Sudan, takaful is in its infancy anyway. Secondly, the coexistence of the two funds is the source of constant discussions about how, if at all, surplus is distributed between them. The shareholders have to inject a considerable amount of money and they want and need to make profits. However, in Islamic finance, money alone may not earn money.

And so we reach an important point: the takaful operators as wakeel need to provide their work and expertise in managing the participants’ fund, not necessarily capital. The insertion of large sums of money into the share-holders’ fund is just a solvency requirement and even somewhat problem-atic, since the qard hasan promise is a financial service akin to a guarantee. There are alternative solutions to ensure solvency: one is retakaful. Another is to put the capital directly into the participants’ fund. Since both funds together function as capital for solvency purposes, it makes no difference for consumer protection in which one the capital is put. The issue of where the surplus belongs would be solved that way, because only the partici-pants’ fund would provide protection and need and deserve the surpluses.

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The idea we should thus like to raise here is to introduce a new kind of takaful operator that maintains only a rudimentary shareholders’ fund at least in the long run, thus being closer to pure mutuals. To our knowledge, nothing in shari’a principles really requires that shareholders’ funds need to be of substantial volume. Realistically, such operators need to get started, of course, and we have several financial solutions to this. A legal form for these may be waqf, not unlike the above-mentioned trust Germany created in 1990. All these solutions can be supported and partly substituted by public or private retakaful.

A master plan for the diversification of the industry

The area of operation for takaful operators of this kind should reflect their aim and creation. If these companies were to enter the existing market (industrial risks, metropolitan areas), provided with zero-cost risk capital, this could justly be considered a competitive distortion. And it would not serve the purpose of infrastructure development.

Such companies should – by and large – be of a semi-public type, with a mission to reach out to remote (at first glance less attractive) areas and seg-ments. Experience in the West has shown that such mutuals (banks in par-ticular) have fared well for many decades, largely undisturbed by crises and supported by their stable, often rural, loyal client base. While decentralised and close to the area they cover, they often establish selective cooperations to create critical mass and to meet the expenses of modern technology, namely for IT systems.

Another, more radical application of this particular structure would be to build up an obligatory social insurance – e.g. for unemployment. In this case, shari’a compliance and its features might help in creating accept-ance and reducing moral hazard.

A third application of this system is in micro-takaful, for obvious reasons.

All these kinds of pure mutual takaful operation – fully private, semi-public, social and micro-takaful – could be combined in a medium-term master plan to enrich variation in social safety nets and cure the dysfunctions described. As mentioned above, we consider that the largest operational obstacle lies in the administration, in the function of wakeel: The profession-alism and service level has to be high, which requires well-educated staff who are prepared to earn rather less than in shareholder-funded companies.

This problem can be overcome by training the well-educated and unem-ployed young citizens, whose abundance has been a main driver of the Northern African revolutions. Thorough studies of the models and experi-

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ences of various types of mutuals and cooperatives in the West and direct know-how transfer through cooperations with Western companies may further help to exploit this unique opportunity for the people. It was done before in Mit Ghamr, and it can flourish again.

Contact

Dr. Ludwig StiftlHead of Centre of Competence RetakafulTel.: +49 89 38 91-24 24 Fax: +49 89 38 91-7 24 [email protected]

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